I often ask myself why people find it so difficult to invest for the long term in the stock market. There are so many trading and demat account holders in India. But so few who are successful investors. My thoughts on this:
The Trading versus investing approaches
These two approaches are so different that perhaps the first step for a novice new investor is to try to understand both these concepts and decide which approach he should start with.
- Trading is the purchase (or sale) of a stock to take advantage of a short term rise (or fall) of the price to make a profit. The ‘short term’ referred to here ranges from a few minutes to a few weeks.
- Inherent in this approach is the need to ‘track your trade continuously’ and to ‘understand price, volume patterns’, a subject well understood by a Technical Analyst.
- The lure of a quick buck attracts a lot of people to trading. The flip side is that there is a big learning curve, and my guess is that 5% of traders make large profits (with learning, luck, experience and the right attitude) while 95% walk away with varying degrees of losses.
- My conviction is that Trading is a zero sum game. So for a particular stock, Profits (by winners) = Losses (by losers) + commissions + taxes.
- Investing is the purchase of part ownership of a business, to have a share in the success of this firm, reflected in terms of revenue and profits (at the corporate level) and dividends and share price appreciation (at the shareholder level). It is generally made for the medium to long term.
- Inherent in this approach is the need to find a company to invest in that is in a growing sector/ industry. It must have good management, that is transparent about their initiatives, financials and challenges. It must be Undervalued (cheap at the time of buying).
- This subject is well understood by a Fundamental Analyst. (Disclosure: JainMatrix Investments is focused on Fundamental Analysis for stocks).
- Investing typically needs the investor to allocate his money for at least 6 months, but more likely 2 years or longer. Thus investors need to have patience and this much time on hand.
- My conviction is that Investing returns from a good portfolio give an exponential gain over time. See Fig 1. The graph illustrates how exponential growth (green) surpasses both linear (red) and cubic (blue) growth.
- In Investing, when there is a success, all shareholders win and profit. Its not a zero sum game. Its actually a meritocracy where the best performing listed corporates spawn the best rewarded shareholders.
- In the long run, on average Indian equities (and Indices) have given 12-14% returns per year.
- My personal conviction is that a novice must enter the market as an investor and learn his lessons over a few quarters before trying his hand at trading. He soon realizes the power of a few clicks of the computer and can take responsibility for his losses (and enjoy the gains). In reality trading attracts novices and he may be burnt very quickly by a few bad experiences.
The Herding Instinct and Contrarian Thinking
Once a person has decided to be an investor, the next big lesson is to learn ‘the Investing Instincts’. And the biggest of them is to resist the Herding instinct.
People collect or herd together in their decisions. They follow the larger group and blindly copy their decisions. But investing in the fundamentals of a company involves understanding the business of a company and taking rational decisions.
- Perhaps the buy decision was on the basis of 2-3 corporate events / initiatives that are likely to play out over 2-3 years. So the investor needs to watch for these events, and once completed successfully, review the investment, and perhaps exit with his profits.
- Perhaps the sector, the management and the brand are identified as so good that the company will weather all storms over say, the next 5 years and continue to win and perform financially.
The challenge to such fundamentals based investment decisions are events within these time spans that cause large share price movements. It could be a Modi government win that causes a 30% upside in the overall market and your investments appreciate 50% (a good problem to have). Or it could be a 10% fall in the market that may cause the firm’s share price to fall 20%.
The opposite of the Herding behavior is Contrarian thinking. The Calm investor has to only make 5-6 big Buy or Sell decisions every year.
- The Modi government win and subsequent 50% upside can be an exit opportunity if a targeted appreciation is achieved. Or it can be ignored if the view is that the upside is higher as the event / initiative is not complete yet, and still to play out. In addition we have an environment of improving market outlook, and still far from bubble territory.
- The 10% fall can be seen by investors as another opportunity to enter the market at lower levels. By those fully invested, this fall can be completely ignored. In the investing world, ‘What goes down has to come back up again’ applies more often than the more popular converse.
Take the current fall in markets. It seems to me that the Sensex move from 20,300 on 7th Feb 2014 to 28,800 on 28th Nov has been a 42% gain over 9 months almost without a break. All big gains are interspersed with small corrections (and the converse). The fall has been anticipated many times over the last 2-3 months. Nobody can predict it accurately. But it is almost a consensus now in the market that there will be a fall.
The investor needs to stay calm and take advantage of it.
Punit Jain is the Founder of Bangalore based firm, JainMatrix Investments that offers Equity Research and Portfolio Advisory Services.